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Brace Your Assets For A Tax Hike In Near Future

OCEAN CITY – While it’s notoriously difficult to predict Washington’s next move, you should probably start preparing yourself for higher taxes. A sweeping series of tax cuts introduced by George W. Bush in 2001 and 2003 are set to expire at the end of this year. It’s unclear yet whether Congress plans to renew some of these tax breaks. Yet even if only a few expire, the impact on your portfolio could be significant. To help offset any impending changes in the code, we believe you should consider implementing several proactive and tax-efficient investment strategies this year.

One very straightforward approach is to consider increasing your municipal bond holdings. With the income tax rate for top earners possibly set to rise to 39.6% from 35%, shielding your investments from federal taxes could become all the more crucial, and municipal bonds are one of the few investment vehicles whose yields are free from federal (and most state) taxes. Yields on 10-year AAA-rated municipal bonds were about 3% in late January. At the current top tax rate, that’s roughly the equivalent of a taxable bond yielding 4.5% for someone in the 28% bracket. At higher tax rates, the comparable yield would rise even higher.

There is one exception to the rule. If you’re subject to the alternative minimum tax (AMT), you will owe taxes on income from a common type of municipal bond known as a private activity bond, issued by local governments to fund the construction of projects involving private contractors.

Congress has discussed eliminating the AMT or limiting its scope, but it’s a major revenue producer, and repeal seems doubtful. Millions more Americans will face the tax this year. Your tax consultant can work with you and your financial advisor to help you determine whether you’re likely to be one of them, and how to adjust your muni strategy accordingly.

Another set of tax strategies involve dividends and capital gains. Since 2003, most dividends and capital gains have been taxed at a maximum rate of 15%. Unless Congress moves to push back the sunset provision governing this portion of the Bush tax cuts, starting next year dividends will again be taxed as ordinary income (and, potentially, at the higher 39.6% rate), and the tax on capital gains will rise to 20%. Your financial advisor can help you decide whether to recalibrate the balance of your portfolio dedicated to dividend-producing stocks. He or she may also want you to take a look at your portfolio’s underperforming assets and consider harvesting some capital losses in 2010 that can be used to offset the effect of the possible increase in the tax on capital gains.

Accounting rules have always allowed taxpayers to use capital losses in one investment to offset capital gains in another. If in a given year you have more losses than gains, you can use up to $3,000 in losses to offset ordinary income. And the losses can be carried forward indefinitely, so any losses booked this year could likely be used to offset taxable capital gains next year (and the year after and the one after that), when it looks as though the tax rate will rise to 20%.

In our estimation, signs point to this being one of the last Aprils with several tax rates and exemptions you’ve no doubt grown used to. Your financial advisor can work with you and your tax planner on these tax-consideration strategies and others to help transition to the Aprils ahead with as little drain on your assets and investment performance as possible.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-852